Exit Opportunities for DPO Investors

When considering an investment in a direct public offering, potential investors may want to understand how they can get their investment back, i.e. their exit strategy. Organizations raising capital via a DPO should expect questions from potential investors on this subject.

An investor’s sale of their investment is itself regulated by securities laws, so in addition to the pragmatic question of finding a buyer, the investor needs a strategy for compliance with these securities laws.

The following summarizes a number of exit strategies that may be available to investors in a DPO, depending on the type of security and other circumstances. The discussion is organized into four sections: i) exit strategies that are built in to the security itself, ii) those that may arise based on future events, iii) those that may be available on an investor’s initiative, and iv) trading mechanisms that maybe available.

I. Exit strategies designed into the security

These strategies are built right into the investment from the beginning and don’t generally raise additional securities compliance issues at the time of the exit.

Debt: Many of our DPO clients offer investment notes, which are debt instruments with a specific maturity date. Of course, an issuer offering debt needs to think about how it will repay the principal at maturity. Some may establish a sinking fund, or will make annual principal payments rather than a balloon payment at maturity.

Revenue share: Also known as revenue-based financing (or RBF), this is an increasingly popular investment model in which payments to investors is a function of the issuer’s top-line revenue, so that the issuer pays less during lean times and more when it’s flush with cash. There are several variations on the theme, but in the most common variations the investor’s rights expire when the investor has received a pre-set multiple of their original investment (typically 2x to 3x).

Preferred stock with redemption feature: Preferred stock can be designed with a built-in redemption feature. There is a lot of flexibility in how to do this. Key decisions for issuers who want to go this route are:

– Who has the right to initiate a redemption? In other words, does the issuer have a call right or do the investors have a put right? Or should it be automatic upon some triggering event?

– When does the redemption right arise? Often it arises after some period of years, say five or seven years.

– How should the redemption price be calculated? To avoid having to pay for a professional appraisal, it could simply be the original purchase price (which means those investors won’t share in any appreciation), or it could be based on some formula based on revenue, profit, or other metrics.

– How should the redemption price be paid out? If it is at the investor’s election, the issuer should have the option of paying in installments over, say, five years.

II. Exit strategies based on future events

These exit strategies involve someone other than the investor taking the lead – someone who typically handles securities compliance issues.

IPO: An initial public offering (IPO) entails a full registration with the US Securities and Exchange Commission (SEC), usually accompanied by a listing on a national trading market, either over-the-counter (OTC) or on a stock exchange (like NASDAQ or theNYSE). This usually allows existing investors to buy and sell their shares freely. For example, Annie’s Homegrown raised capital through a DPO in 1995 and then went public with an IPO in 2012.

Merger or Acquisition: A number of companies that have done a DPO have subsequently been acquired by a larger company. Perhaps the most prominent example of this is Ben & Jerry’s, which completed their a DPO in 1984 and was later acquired by Unilever in 2000. Annie’s Homegrown, following its IPO, was acquired by General Mills in 2014. When an acquisition happens, the acquiring company makes a tender offer to all shareholders to purchase their shares, often in cash at a premium over what investors paid. Sometimes, if the acquiring company’s stock is publicly traded, it may offer to exchange the shares of the acquired company for its own shares, which can then be sold.

Listing on the OTC Market, or stock exchange: Even without going public via a full IPO, a company that has raised capital via a direct public offering may decide to register its shares to trade on a national market such as NASDAQ or the NYSE. Since doing so does not raise capital and can be expensive to accomplish, however, there may be little incentive for the company to go this route.

Issuer’s Tender Offer: Even if an investment has no built-in redemption feature, an issuer can still redeem investments by making a tender offer. This typically occurs in conjunction with a new investment into the issuer — so the new investment proceeds are used to DPO. The issuer has some flexibility as to which classes of investment and which investors it will redeem; and it can structure the transactions so only a portion of the new investment will be used to redeem earlier investors, so as to have a net new infusion of capital. As with other types of securities transactions, tender offers must comply with a set of rules that govern them.

III. Exit strategies at the investor’s initiative

If none of the strategies above are available to an investor who wants an exit, there are other ways to sell an investment, as long as the investor is careful to comply with securities laws. These laws generally forbid an offer or sale of an investment unless it is either registered or exempt from registration; and this is true at both the state and federal level.

Federal law provides an exemption from registration for sales by someone other than the issuer, an underwriter or a dealer. While that would appear to allow secondary sales by an investor, there is an important nuance: A selling investor might inadvertently be deemed an underwriter. In other words, if an investor buys shares of stock in a DPO and then later turns around and sells them (a “secondary sale”), the investor could be deemed to have participated in a distribution on behalf of the issuer. In that case, the exemption is not available.

However, there are three strategies an investor can use to ensure that a sale of their investment complies with federal law:

Rule 144 sales: Under Rule 144, if an investor that is not an affiliate of the issuer (that is, not an officer, director, or 10% shareholder of the issuer) holds the investment for one full year, they can’t be deemed an underwriter and can sell the investment. However, the investor would also need to comply with their state’s securities laws.

Private sales: Another way to ensure the investor is not deemed an underwriter, even if a full year has not elapsed, is to offer and sell the investment privately. This requires that the investor have an established relationship with someone before offering the investment to them. As with Rule 144, the investor would also need to comply with state securities laws.

Section 4(a)(7) sales to accredited investors: Section 4(a)(7), which was added in 2015 to the 1933 Securities Act, provides a new exemption from registration for secondary sales to accredited investors, as long as there is no advertising and as long as the issuer provides disclosure of key information about the company. This is a federal exemption that preempts state law, so investors don’t need to be concerned about their specific state rules. An individual is accredited if they have either $1 million in net assets excluding their primary residence, or $200,000 in annual income (or $300,000 together with their spouse).

With secondary sale strategies that also require compliance with state law, the selling investor is responsible for understanding what their particular state requires. In California, for example, Corporations Code section 25104(a) provides an exemption for secondary sales if there is no advertising and the sale is not conducted through a broker-dealer in a public offering. Many states have a similar exemption.

An investor looking to sell their investment should be aware of other restrictions that may be imposed due to the nature of the original offering. Perhaps most prominently, if the investment was made in an intrastate offering (a common DPO strategy), the investment may not be resold to a resident of another state for at least six months after the date the investment was made in the intrastate offering.

IV. Secondary Sales Mechanisms

The above strategies are the legal compliance strategies. Some practical mechanisms for secondary sales under these legal strategies include:

Broker-managed trading platform: Companies like NASDAQ Private Market (which acquired SecondMarket), OpenShares, andSharesPost operate platforms on which securities acquired in a DPO can be sold. Since they receive compensation for their services, these platforms need to be licensed as a securities broker-dealer.

Trading bulletin board hosted by issuer: This may be similar to a broker-managed platform; but as long as the issuer is not receiving any compensation for facilitating securities transactions, it does not need a securities broker-dealer license.

Privately negotiated sales: An investor can sell their investment in a private transaction to a buyer in their network, as long as they follow the rules, such as not advertising or announcing the potential sale in any public way.

Looking ahead…

While there are a number of exit strategies available, each has its limitations, and an investor in a particular situation may very well find that none of them is feasible. One of our goals is to eliminate barriers to a vibrant and efficient community capital market. Therefore, we are exploring two possible strategies that could help alleviate investor concerns about a future exit from a DPO investment:

– A nonprofit market participant that can purchase securities that were acquired in a DPO, hence creating a kind of market appetite. It could raise capital via a debt offering (like other nonprofit investment funds).

– A for-profit investment fund that would invest in DPOs, as well as in privately offered securities of social enterprises. As an open-ended fund, it would itself issue shares to investors and redeem them as needed.